Turkey - Programmatic Financial and Public Sector Adjustment Loan Project

Report No. PID10510 Project Name Turkey-Programmatic Financial and Public... Sector Adjustment Loan Loan amount US$1.1 billion (US$700 million on standard IBRD terms and US$400 million on special IBRD terms) Region Europe and Central Asia Sector Private and Financial Sector Development Poverty Reduction and Economic Management Project ID TRPE70561 Borrower Government of Turkey Implementing Agency Undersecretariat of Treasury Ankara, Turkey Environment Category C Date This PID Prepared June 25, 2001 Date Initial PID Prepared N/A Appraisal Date May, 2001 Projected Board Date July, 2001 Country and Sector Background 1. In late February 2001, Turkey experienced a major currency crisis which forced the Government to abandon the exchange rate based disinflation program and float the Lira. The immediate cause of the crisis is attributable to weaknesses in the financial sector, but its deeper roots lie in the structure and management of the public sector which are at the core of Turkey's chronic macroeconomic instability. The combination of an oversized public sector living beyond its means and inadequate management of existing resources has generated structural imbalances which have thwarted successive attempts at disinflation. These imbalances and the constant search for financing have become intertwined with financial sector weaknesses in a vicious circle. The state banks were traditionally used to finance Government-mandated subsidized lending to agriculture and SMEs. This recourse to quasi-fiscal financing directly undermined financial sector stability. In parallel, the emergence of a lucrative domestic market for high return Government bonds indirectly contributed to financial sector instability as banks became dependent on artificially inflated profits from investments in Government paper. Faced with prohibitively high interest rates, the Government traditionally relied on the inflation tax to keep the public debt under control. However, this created a deeply ingrained pattern of inflationary expectations which has blocked financial sector deepening and promoted steadily increasing currency substitution. 2. A disinflation program launched in late 1999, based on a nominal exchange rate anchor was a bold and risky attempt to break the unsustainable cycle of inflation, financial sector weakness, high interest rates and ever increasing public indebtedness. The program included ambitious structural reforms. A major reform of the public pension system was undertaken in August 1999 and ambitious reforms were launched in the agriculture, energy  and telecommunications sectors. In the financial sector, a new commercial bank law was passed in December 1999 that called for the creation of a new independent bank regulatory agency, initiated a much needed overhaul of the banking sector regulatory regime and enhanced the powers of the SDIF, the agency responsible for bank failure resolution and administration of the deposit insurance scheme. After some early success including a rapid decline in interest rates, there was soon resistance to change from within the governing coalition. As implementation progressed during the course of 2000, resistance to particular aspects of the program became more pronounced. The macroeconomic risks quickly built up and the program eventually collapsed at its weakest point, the financial sector. 3. The Government has prepared a new economic program that aims to minimize the short-term impact of the crises while setting the stage for an early resumption of disinflation and growth. The program targets a more gradual disinflation path, but a more aggressive push on structural reforms. By moving immediately to address the fundamental structural problems underlying the crisis, with a strong focus on restructuring the banking sector, the Government hopes to engineer a quick recovery closer to the experience of Brazil and Korea, and avoid the prolonged recession that some other crisis countries have experienced. The program is based on a three- pronged strategy: (i) macroeconomic policies geared towards restoring financial stability and resuming the disinflation process; (ii) structural policies aimed at correcting the financial sector and public sector weaknesses underlying the crisis and establishing a more sound basis for disinflation and growth; and (iii) strong social policies including enhanced social dialogue to achieve price and wage policies consistent with macroeconomic stability, and increased emphasis on the protection of the most vulnerable groups of society. The Country's Financial Sector Reform Program 4. In the aftermath of the November 2000 and February 2001 banking crises, the Government has committed itself to a significant acceleration and widening of the scope of the financial sector reform effort. Such acceleration and widening of the scope of the financial sector reform program is clearly necessary to restore banking system confidence and put the banking system on a sustainable path towards competitiveness at the international level and towards EU accession. As part of the widened scope of its financial sector reform effort, and once the initial phase of immediate urgent post-crises banking sector reform and restructuring activity is over, the Government will also implement a comprehensive non-bank financial institutions reform program, to complement the banking sector reform effort. Currently, NBFI activity in Turkey is still limited, however, it is anticipated that NBFI activity could grow significantly once the macro- economic situation stabilizes. As banks are the key players in NBFI activity, and as it is anticipated that in the aftermath of the banking crisis stronger, larger banks with a universal mandate will appear, a proactive approach on the part of the Government will be necessary to manage the risks and vulnerabilities of such rapid NBFI growth. 5. As the experience in other crisis countries (e.g., East Asia, Latin America) has shown, banking crises resolution efforts will take time. Therefore, the Government has structured its financial sector reform effort in two phases, with the first phase focused primarily on implementation of urgent banking system reform and restructuring efforts, and the second phase - 2 -  focused more on the medium term broad based financial sector development agenda. As such, this effort will stretch over multiple years. 6. The initial phase of the Government's multi-year reform program will focus on measures in the following four areas: (i) acceleration of the overhaul of banking system prudential regulation; (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA); (iii) accelerated resolution of problem banks and failed banks already taken over by the SDIF; and (iv) initiation of comprehensive financial and ownership restructuring of the four major state-owned banks. The second phase of the reform program will focus on: (i) finalizing the overhaul of the banking system prudential regime; (ii) continued institutional development of the BRSA and initiation of a comprehensive institutional development effort at the Savings Deposit Insurance Fund (SDIF); (iii) continuation/completion of the problem bank/failed bank resolution effort; and (iv) further restructuring and privatization of the state-owned banks. The follow-up reform efforts in the banking area (especially the completion of the state bank privatization effort) as well as the reform efforts in the NBFI segment of the financial sector will be rolled out during 2002 and early 2003. The Country's Public Sector Reform Program 7. The Government's public sector reform program aims to underpin sustained fiscal adjustment and create the conditions for transparent and effective government. In combination with the financial sector reform program, the public sector reform program addresses the underlying structural factors that led to the crisis, thereby trying to ensure that these conditions do not recur in the future. In particular, the program aims to break the vicious circle of inadequate public sector management leading to ever increasing public indebtedness that fuels financial sector weakness through dependency on high return government securities which in turn inflates the public debt burden. The reform aims to achieve permanent fiscal adjustment; as well as radical improvements in public policy formulation, the framework for resource mobilization and allocation, the system of public oversight and accountability, and public sector governance. This is an agenda for modernizing the Turkish state to meet the challenges of the new century. 8. The program focuses on three critical areas, each of which has a medium-term dimension; (i) implement structural fiscal policies to ensure permanent fiscal adjustment; (ii) launch a medium-term program of policy and institutional reforms to improve the transparency and efficiency of public expenditure management (PEM) including action to improve budget preparation and execution, policy formulation, and the operational performance of public agencies; and (iii) initiate broad based institutional reforms to improve the quality of public sector governance. In each of the these areas, the Government has developed or is preparing a strategic approach to guide its actions over the next three years. ? In the area of structural fiscal policies, the approach will be based on (i) a medium-term strategy for improving the tax system and (ii) a comprehensive program to adjust staffing levels in the central government and SEEs, both of which are to be prepared and adopted during the remainder of 2001. ? With regard to public expenditure management, the Government has prepared a three year Strategic Framework for Public Expenditure Management Reform. ? In the area of public sector governance, the Government is preparing a - 3 -  national strategy for improving governance and combating corruption which it intends to finalize by late September and adopt and publish before the end of the year. 9. The initial phase of the multi-year reform program will focus on sustaining the fiscal adjustment and setting into motion the key change processes for institutional reform including measures in the following four areas: (i) implementation of structural fiscal polices to support the primary surplus targets for 2001 and beyond; (ii) initiation of the PEM reform process including preparation of key legislation to underpin improvements in financial accountability (procurement) and public liability management; and (iii) initiation of work on a national strategy to improve governance and fight corruption. The second phase of reforms will focus on: (i) deepening structural fiscal policies paving the way for permanent fiscal adjustment; (ii) implementation of the first phase of the PEM reform on a pilot basis in the 2002 budget and rationalization of the public investment program (PIP); (iii) enactment of legislation on public procurement and public debt management; and (iv) adoption and publication of the national anti-corruption strategy. Subsequent reform efforts, including rollout of the PEM reform, steps to adjust staffing in the government and state economic enterprises (SEEs), and deeper institutional changes in the areas of tax administration, financial accountability and public sector governance--including civil service reform--are planned for late 2002 and beyond. The Proposed Loan Program 10. The proposed US$1.1 billion (US$700 million on standard IBRD terms and US$400 million on special IBRD terms) Programmatic Financial and Public Sector Adjustment Loan (PFPSAL) is the first Loan in support of the Government's multi-year financial and public sector reform program. It is envisaged that the proposed PFPSAL will be followed by a second Programmatic Financial and Public Sector Adjustment Loan (PFPSAL II) of US$1.35 billion (US$550 million on standard IBRD terms and US$800 million on SSAL terms), tentatively planned for December 2001. The main objective of the proposed PFPSAL is to address the Government's immediate financial and public sector reform priorities in the aftermath of the November 2000 and February 2001 financial crises, while ensuring that social programs continue to be adequately funded. Key priorities include, in the financial sector: (i) overhaul of the regulatory framework for banking activity, (ii) institutional development of the new Bank Regulation and Supervision Agency (BRSA), (iii) problem bank/bank failure resolution, and (iv) state bank restructuring and privatization; and in the public sector: (i) structural fiscal policies, (ii) public expenditure management, (iii) financial accountability, (iv) public liability management, and (v) public sector governance. The PFPSAL will provide budgetary support to help the Government finance the costs arising from the crisis while continuing to fund its critical social programs. 11. The principal benefits of the Loan will be to: (i) restore confidence in the banking system and in the Government's ability to implement and sustain the required sizeable fiscal adjustments following the November 2000 and February 2001 crises; (ii) strengthen the foundation for an efficient and sound banking system which can be competitive in quality and performance at the international level; (iii) reduce the vulnerability of the banking system and enhance its capacity to withstand external shocks and thereby reduce systemic failure risk; (iv) position Turkey's banking sector for accession to the European Union (EU) by starting the process of aligning the prudential - 4 -  regime for the banking system with applicable EU banking sector directives; (v) support urgent fiscal measures to respond to the crisis while ensuring that social spending is protected; (vi) lay the foundation for sustained fiscal adjustment; and (vii) modernize the public sector through actions to improve management of public expenditure and liabilities, ensure financial accountability in line with international standards, and raise the quality of public sector governance. 12. The risks associated with the Government's financial and public sector reform program arise from macroeconomic factors, a potential loss of political consensus and institutional weaknesses. The key macroeconomic risk is that interest rates will remain higher than projected which would affect the sustainability of the public debt and create the conditions for renewed instability. Given the severity of the February 2001 crisis, Turkey will remain vulnerable to both internal and external shocks over the medium term. The commercialization and privatization of the state-owned banks will be a major political and organizational challenge for the Government and will also have significant fiscal and social implications. Another risk is that of possible inability to raise sufficient resources to finance the restructuring of the state banks and the resolution of the banks under the Savings Deposit Insurance Fund (SDIF). Tight fiscal discipline and the confidence of domestic and international investors in Turkish sovereign debt instruments will be essential here. Finally, satisfactory and timely failure resolution efforts by the SDIF and enforcement of capital restoration plans by the BRSA are important; the risk that such efforts will fall short of what is needed is related to the political pressure that may be put on these agencies for a slowdown of regulatory enforcement action and general regulatory forbearance. The public sector reform agenda is politically sensitive and may be jeopardized by resistance of vested interest groups that would prefer to maintain the status quo. Capacity constraints and crisis management efforts at key Government agencies, such as the Ministry of Finance and Undersecretariat of Treasury, may also slow down the pace of the envisaged public sector reforms. Contact Points: Lalit Raina, ECSPF The World Bank 1818 H Street N.W. Washington, DC 20433 Tel No.: (202) 458-2900 Fax No.: (202) 522-0005 James Parks, ECSPE The World Bank Ugur Mumcu Caddesi No. 88 Ankara, Turkey Tel No: (90-312) 446-3824 Fax No.: (90-312) 446-2442 Note: This is information on an evolving project. Certain components may not necessarily be included in the final project. This PID was processed by the InfoShop during the week ending July 13, 2001. - 5 -